IPO Valuation

The IPO valuation is one of the critical steps in the IPO process that helps determine the price of an IPO. An IPO valuation is a complicated task that requires expertise and in-depth knowledge of financial concepts and the market / industry as a whole. A merchant banker assists the issuing company in the valuation process.

IPO Valuation meaning

IPO valuation is a process to determine an appropriate valuation of the company to help determine the correct IPO price.

There are several factors that affect the valuation of a company. The merchant banker must analyse all of these factors in detail. This data is then submitted to SEBI in the draft IPO prospectus, which explains the basis for determining the price. SEBI thoroughly evaluates and analyses the data to ensure that investors' money is in safe hands.

It is very important to price the stock correctly because an overvalued stock may not attract many investors and an undervalued stock may create doubts amongst investors.

Factors impacting IPO valuation

The valuation of an IPO is the result of the health and performance of the company. Additionally, there are several other components like industry scenarios and market conditions that affect the valuation. The following are the factors that influence IPO valuation:

1. Demand

   Generally the higher the demand for a stock, the higher is its price. This is because investors are willing to pay a heavy price if they really want to be invested in the company.

   However, investors should be aware that this factor alone is not enough to judge the IPO. It can sometimes be an inaccurate indicator. For example, Paytm and LIC IPO, were in high demand. Both were expected to go public at a premium, but both stocks got listed at a discount of 8-9%, causing investors to suffer losses.

2. Past Financial Performance

   A company's financial track record plays an important role in its valuation. Quantitative financial factors that form the basis for pricing an IPO include the company's:

   • Assets,
   • Liabilities,
   • Ability to generate revenue,
   • Income, Earnings per share (EPS),
   • Price-to-earnings ratio (PE),
   • Return on net worth, and
   • Net asset value per share.
3. Peer Comparison

   The valuation of an IPO company is usually aligned with companies in the same industry. Therefore, an issuing company reviews the valuations and current market price of stocks in the same industry. If the valuations differ too much, investors tend to hesitate to invest in the company.

4. Potential Growth Rate

   Investors are attracted to companies that have good future prospects. For example, a company that intends to raise funds for business growth may be valued higher than a company whose goal is to pay down debt.

5. IPO Timing and Market Trend

   Market trends and timing also affect a company's valuation. If the market is in a downtrend, a higher valuation will not attract investors.

6. Products and Services

   The products offered by the company can also affect the company's pricing. If a company offers products and services that improve the lives of an average person or are considered under necessities, the IPO may attract a higher price.

7. Company management and values

   Companies with experienced management, strong promoters, and a good corporate history, attract a higher valuation and the IPO prices may be higher.

IPO Valuation Process

Given the wide range of factors, IPO valuation is an extremely complex process performed by trained merchant bankers. Merchant bankers have the expertise and knowledge to understand and analyse all factors impacting the IPO valuation.

To derive the valuation of a company, a merchant banker has to:

1. Gather all previous data and details of the company, including its financials.
2. Analyse the data.
3. Get the data audited.
4. Map the competitive valuations.
5. Analyse all factors that affect the valuation.
6. Adopt one or more IPO valuation techniques to derive the valuation.
7. Include the information in the draft document.
8. Submit the data to SEBI for analysis and approval.

IPO Valuation Methods

There are various valuation methods available for IPO valuation calculation. A merchant banker could use any one or a combination of one or more valuation methods to arrive at an appropriate valuation. Some IPO valuation calculations are purely mathematical calculations, while others are based on relative approaches, experience and assumptions. Let us take a look at some of the main methods used by companies to determine their stock price.

1. Relative Valuation Method

Relative valuation is also known as the comparable valuation method or IPO valuation using multiples. In this method, merchant bankers compare key ratios of similar publicly traded companies in the industry to get an idea of the value investors are willing to pay for those companies. These comparisons include ratios pertaining to :

• Revenue,
• Earnings, and
• Market capitalization.

Based on these comparisons, the merchant banker determines the valuation of the issuing company.

Steps in relative valuation method

The relative valuation method is a simple 4-step process that requires solid analytical skills and market knowledge.

• Look for similar companies in the industry.
• Determine IPO valuation multiples for comparison. These include price-to-earnings ratio (PE), enterprise value (EV), earnings per share (EPS), earnings before interest, taxes (EBIT) and much more.
• Compare the above values of all similar companies.
• Determine the value of the issuing company after adjusting certain factors such as strength, risks and growth potential, which may be different for each company.

Let us take a simple example to understand the above concept of relative valuation using the Price to Earnings multiple valuation that will assess rough valuation of the business based on its earnings after interest, tax and depreciation (EBIT).

Example : You want to assess the valuation of your business that is in the IT sector. As a first step, check for the PE ratio of the IT services industry from eqvista OR Getmoneyrich.com. Say the PE ratio of IT sector is 24%.

Let us assume the EBIT for your business is Rs 15.75 crores. Considering your business is new, it is better to take half of the IT PE ratio or less than that and check for a range of PE to get a fair idea of valuation of your business. We will take a PE ratio in the range of 15-20% and get a rough valuation figure for the business using the below formula.

PE Multiple Valuation = PE Multiple * EBIT

Note: Use our Business Valuation Calculator for more details.

Considering the above formula, we see that the valuation of the company ranges anywhere around Rs. 240 crores to Rs. 315 crores.

2. Absolute Valuation Method

The absolute valuation method considers future cash flows to determine the current value of the company. The absolute valuation method is performed in a standalone mode. This means that it focuses only on the characteristics of the company. It does not compare the characteristics or value of other companies in the same sector.

Absolute valuation helps in the mathematical calculation of the intrinsic value of the company. These are based on certain assumptions like, future cash flows get projected and discounted to determine the current value of the company. The projected cash flows can be in the form of profits, free cash flows, dividend income, etc. This approach relies on the time value of money.

The absolute valuation approach is challenging because it relies on long-term forecasts and assumptions that can change due to unforeseen factors.

Steps to value a business using Absolute Valuation approach:

• Define a period and complete the cash flow projection for the period.
• Derive the weighted average cost of capital (WACC). This denotes an investor's expected rate of return. The WACC is taken as the discount rate.
• Calculate the present values of the cash flows for each year by dividing the projected cash flow by 1 plus the discount rate raised to the power of the year i..e 1 for Year 1 , 2 for year 2 and so on.
  For instance, Projected Cash Flow for the first Year is 1/(1+ Discount rate)¹
• Add all the projected cash flows derived as per above formula for each year.
• Derive the terminal value.
• Add the terminal value to the discounted cash flow of all years to arrive at the present value of the business.

The absolute value of the business for 5 years will look like below:

Absolute value of a business assuming cash flows for 5 years = Cash Flow for Year 1/(1+WACC)¹ + Cash flow for Year 2/ (1+ WACC)²+ Cash Flow for Year 3/(1+WACC)³+………………+ Cash flow for Year 5/(1+WACC)⁵+ Terminal Value /(1+WACC) ^{last year of projection}

The lead managers also have the choice of ready-made IPO valuation model excel templates for quicker and easier calculation. However, the lead manager still has to ensure projecting the right values and setting the right multiples/factors. This requires a lot of effort in examining minute details of the company and analysing the growth path of a company.

Let us take a simple example to understand the derivation of absolute valuation based on projected and discounted cash flows.

Assumptions:

• Projected growth in revenue: 20%
• Discounting Rate: 15%
• Terminal Value: 5%
• Operational expenses (OPEX): 15% of the revenue
• Tax Rate: 25%

Derivation of valuation considering projected growth rate for 5 years.

Note: Business Valuation Calculator (DCF Calculator) for more detail.

*Terminal Value = (PAT of last forecasted year*(1+Terminal Value %))/ (Discounting Factor-Terminal Value%) *Discounted Cash Flow of last forecasted year)

3. Economic Valuation Method

The economic valuation method is a purely mathematical, formula-based method of determining the value of a company based on the company's debt, market capitalization, income, assets, and other economic factors.

In this method, there are no comparisons or assumptions as in the relative and absolute valuation methods.

Below is the IPO valuation formula to determine the enterprise value using the economic valuation approach:

Enterprise value + Cash and Cash Equivalent- Value of debt and other liabilities

All three of the above methods have their own advantages and disadvantages. The merchant banker decides on the best approach based on his experience, expertise, business objectives and market conditions.

For example, during a recession, the relative method may not be the best option. The overall market would be affected, and a comparison with other companies would not yield the highest valuation. Also, you may not be able to find appropriate comparables for your company. In such a situation, • Merchant bankers would generally go for the economic valuation or absolute valuation. In certain cases, predicting future earnings may be difficult. In such a case, other valuation methods may be used.

These techniques require apt skills and knowledge. The issuing company and merchant banker generally take the help of a third party valuer who professionally manage the valuation process with their expertise. They charge a fee of Rs 3 lakhs to Rs 8 lakhs depending on the issue size and the complexities involved in the business.

Apart from the above methods, the issuing company also determines the valuation of their company based on the rounds of earlier fund raising. For example, if the issuing company got Rs 5 lakhs against 10% equity, the valuation of the company would be determined to be Rs 50 lakhs. (Derivation: If 10% is Rs 5 lakhs, then 100% would be the valuation of the company). This method of self-assessment by the issuer company or the merchant banker is free and gives a fair idea about the company valuation to the issuer.

Valuation of IPO in India

IPO valuation in India is done by qualified merchant bankers. The merchant banker reviews and analyses every little detail of the company. This includes internal business metrics, key performance indicators, previous financings, market situation and data from other companies. These help the merchant banker decide on the best valuation approach for the company. The merchant banker is responsible for having the data reviewed and for disclosing all information considered in pricing the IPO in the offering documents under the section titled "Basis for Offer Price/Issue Price".

SEBI shall analyse the information and in case of any queries, may issue an opinion or approve the implementation of the IPO.

IPO Pricing and Valuation

Often the terms IPO pricing and IPO valuation are used interchangeably. There is a difference between these two terms.

IPO valuation is one of the factors that form the basis for pricing an IPO. IPO valuation is a process that helps determine the IPO price as seen in the IPO pricing chapter.

Page Glossary

1. Terminal Value

Terminal value is the estimated value of business beyond the projected timeline . It is very difficult to make right predictions for a longer period beyond 5 years and hence is the importance of terminal value.

Terminal value can be derived based on either of the two approaches.

Approach 1: It is expected that the business will be sold based on certain multiples.

Approach 2: The business will continue till eternity with a certain perpetual growth rate.

2. Intrinsic Value

The intrinsic value is the actual value or the real worth of the stock/company that is derived based on fundamental and technical analysis of the company.

The intrinsic value is different from the market value. The market value is the value of the stock/company the investors are willing to pay. Whereas the intrinsic value is the actual value based on its assets, risks, projected cash flows, financials, etc.

When the market value is more than the intrinsic value, the stock is said to be overpriced, whereas when the market value is less than the intrinsic value, it is said to be under priced.

3. Weighted Average Cost of Capital

Weighted Average Cost of Capital is commonly referred to as WACC.

WACC is the cost a company is required to pay to raise capital through debt or Equity.

If a company raises funds in the form of debt, the interest portion becomes the cost of debt. If a company raises funds by issuing Equity, the return expected by shareholders becomes the cost of equity.

To derive WACC, a company needs to proportionately calculate the costs based on the mode of raising capital.

4. Undervalued Stock

An undervalued stock is a stock with a lower market price /value compared to its true worth.

A stock is said to be undervalued, when it is priced much below its potential. The undervalued stocks are believed to give assured profits, but it may take time to show their real value. Thus, only long term investors invest in undervalued stocks after extensive research and analysis.

For example : When the estimated valuation of ABC shares is believed to be Rs 1500 per share, but the stock is trading at Rs 950 per share, then such shares are said to be undervalued.

There are various reasons and factors that can lead to undervaluation. One of the major causes of undervaluation is an overall downward market trend.

5. Overvalued Stock

An overvalued stock is a stock with a higher market price /value compared to its true worth.

A stock is said to be overvalued, when it gets priced higher than its potential. The overvalued stocks can churn profits in the short term. Investing in overvalued stock makes timely exit important. An overvalued stock will return to its intrinsic value/true worth leading to heavy losses. Thus, only experienced investors invest in overvalued stocks as they know how to make the entry and exit at the right time.

For example: When the estimated valuation of ABC shares is believed to be Rs 1000 per share, but the stock is trading at Rs 1500 per share, then such shares are said to be overvalued.